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EU publishes draft directive to combat misuse of shell entities

Overview

The EU Commission has published a draft directive (ATAD 3) designed to tackle misuse of "shell entities". Essentially, these are entities resident in EU member states that do not have sufficient substance. The directive is likely to mean that many businesses will need to take steps to bolster the substance of their EU holding companies to prevent additional reporting or adverse tax consequences, and may increase the comparative attractiveness of the UK's new qualifying asset holding company (QAHC) regime (for more detail please see our QAHC briefing).

As discussed in more detail below, entities within the scope of the directive are subject to adverse tax consequences. There are also increased information reporting requirements which extend to entities at risk of being within scope as well as those that actually are.

Although the use of the term "shell" in the title of the directive may, for many, connote entities engaged in tax avoidance or "letterbox companies" with no substance at all, the basic scope of the directive is fairly wide, potentially catching many holding companies commonly used in business structures, so the various exemptions will often need to be considered carefully.

We set out below a flowchart to help businesses navigate the new rules and assess whether the directive is likely to apply to them.

Which entities are within scope?

The provisions would only apply to all entities that are tax resident in an EU Member State. There is no de minimis threshold or exemption for SMEs. 

Entities are within scope if they pass through an initial gateway, designed to filter out those not at risk. The gateway looks at whether the entity carries out cross-border activities which are geographically mobile and has outsourced its day-to-day management and significant decision making. Those entities that pass through the gateway will be subject to additional reporting requirements. If the entity cannot prove that they meet substance requirements or claim an exemption, adverse tax consequences apply.

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1 Broadly mobile or passive income and includes interest, dividends, rental income, income from financial activities, income from services outsourced to associated enterprises and income from high value private moveable property (e.g. yachts and art collections).

These conditions are that the director:

  • is qualified and authorised to take decisions in relation to the activities that generate relevant income or in relation to the undertaking's assets;
  • actively and independently uses this authorisation on a regular basis; and
  • is not an employee of an enterprise that is not an associated enterprise and doesn't perform the function of director for other enterprises that are not associated enterprises.

What are the tax consequences of having an EU shell in a structure?

If enacted, ATAD 3 will require EU member states to partially look through EU shell entities, meaning that, broadly, where amounts are paid to the shell entity, the jurisdictions (if in the EU) of the payer and shell entity's shareholders will treat the income as flowing directly to the shell entity's shareholders. In addition, the EU Interest and Royalties Directive and the EU Parent Subsidiary Directive will no longer be applicable to the shell entity, potentially resulting in tax leakage to structures. 

The proposed provisions will not affect the tax residency of the shell entity, or the right of the jurisdiction in which the shell entity is tax resident to tax income and gains received by the shell entity. However, in order to ensure that the EU shell entity can no longer access treaty benefits, the EU shell entity Member State must either no longer issue tax residency certificates to the EU shell entity or issue such certificates with a warning that the shell entity is not entitled to benefits under a double tax treaty or under the EU tax directives.

Failure to report or filing a false report will result in a penalty to be set by the relevant Member State, which is required to be at least 5% of the shell entity's turnover.

ATAD 3 also contains provisions requiring the gains on the disposal of certain property (including real estate) to be taxed as if it were held directly by the shell entity's shareholders.

Information exchange and audits

EU Member States will be required to report annually to the European Commission on the operation of ATAD 3. Required reporting will include numbers of entities passing through the gateway, numbers of entities that rebut the presumption and numbers of entities that successfully claim an exclusion. EU Member States will also be able to request that another Member State carries out an audit into an entity resident in that jurisdiction.

Next steps

The draft directive needs to be passed into EU law. If enacted as drafted, ATAD 3 then will be required to be implemented into the domestic law of EU member states by 30 June 2023 and will come into force on 1 January 2024.

The inability to access treaty benefits could have significant implications. Entities that are tax resident in EU member states should begin to consider whether or not they will pass through the gateway, and if so, should consider the impact of enhanced reporting and any consequences of being unable to meet substance requirements.

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